The Taxation of a Gift or Inheritance from an Employer

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The Taxation of a Gift or Inheritance from anEmployer.Douglas A. KahnUniversity of Michigan Law School, [email protected]

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Recommended CitationKahn, Douglas A. "The Taxation of a Gift or Inheritance from an Employer." Tax Law. 64, no. 2 (2011): 273-300.

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The Taxation of a Gift or Inheritance froman Employer

DOUGLAS A. KAHN*

Section 102(a)' excludes from gross income property acquired by "gift,bequest, devise, or inheritance." The oft-quoted standard for determin-ing whether an uncompensated transfer qualifies as a gift is set forth in theSupreme Court's 1960 decision in Commissioner v. Duberstein, as a transferpreceding from "detached and disinterested generosity" and not in return forpast or future services. 2 The crucial factor in applying the Duberstein stan-dard is the intention that the transferor had in making the transfer;' however,there are situations in which that standard should be modified by taking intoaccount the circumstances of the transferee.

In the Tax Reform Act of 1986, Congress added subsection (c) to section102 to replace the subjective Duberstein standard with a more objective rulein one specific situation.' Section 102(c) provides that the exclusion fromincome of section 102(a) cannot apply to a transfer from an employer to, orfor the benefit of, an employee.' The focus of this Article is to examine thefollowing questions: (1) whether, despite its unrestricted language, section102(c) does not apply to some gratuitous transfers to an employee; (2) if so,what are the exceptions to section 102(c); and (3) when section 102(c) doesnot apply to a transfer, whether it will be excluded from income.

If section 102(c) does not apply to an inter vivos transfer to an employee,the transfer must then satisfy the Duberstein standard to qualify as a gift. PartII of this Article examines the conditions under which a gratuitous transferto an employee will be excluded from income under the Duberstein stan-dard and under the normal tax treatment of testamentary transfers-in otherwords, how the section 102(a) gift and bequest exclusion from income isapplied when section 102(c) is inapplicable. Part III examines the operationof section 102(c).

'Paul G. Kauper Professor of Law, University of Michigan. The author thanks ProfessorsKyle Logue and Jeffrey Kahn for their very helpful comments and criticisms.

' Unless otherwise indicated, any citation in this Article to a section number is to a sectionof the Internal Revenue Code of 1986.

2363 U.S. 278 (1960); see also Bogardus v. Commissioner, 302 U.S. 34, 43, 45 (1937).3Duberstein, 363 U.S. at 285.4I.R.C. § 102.51.R.C. § 102(c).

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Before examining the application of the Duberstein standard to employeegifts, it is useful to put that standard in context by considering a policy jus-tification for excluding gifts from the donee's income. The determination ofwhether a specific transfer qualifies as a gift for tax purposes should considerwhether treating the transfer as a gift would be consistent with the policyreasons for allowing an exclusion. Professor Jeffrey Kahn and I examined thatissue in a 2003 article and proposed a principled rationale for the exclusion.'The brief discussion of this issue in Part I is drawn from that article, and theposition of the Author on that issue and response to contrary views are setforth more thoroughly in that earlier article.

I. Policy Justification for Exclusion of Gifts

A number of commentators maintain that there is not a valid policy justi-fication for excluding gifts, which therefore should be made taxable to thedonee.7 To the contrary, the Author contends that there is a valid justificationfor the exclusion. Ironically, the justification is grounded on principles encap-sulated in the well-known Haig-Simons definition of income-popularizedby Henry Simons in the book where he first described that definition.' It isironic because it is in that same book that Simons advocated that gifts shouldbe included in income.

Simons defined income as the

sum of (1) the market value of rights exercised in consumption and (2) thechange in value of the store of property rights between the beginning andthe end of the period in question. In other words, it is merely the resultobtained by adding consumption during the period to "wealth" at the endof the period and then subtracting "wealth" at the beginning.'

'Douglas A. Kahn & Jeffrey H. Kahn, "Gifis, Gafts and Gefis"The Income Tax Defini-tion and Treatment of Private and Charitable "Gifts" and a Principled Policy Justification for theExclusion of Gifrsfrom Income, 78 NOTRE DAME L. REv. 441 (2003); see also Richard Schmal-beck, Gifts and the Income Tax-An Enduring Puzzle, 73 LAw & CONTEMP. PROBs. 63 (2010).

7Eg., HENRY C. SIMONs, PERSONAL INCOME TAXATION 56-58 (1938); Joseph M. Dodge,Beyond Estate and Gifi Tax Reform: Including Gifis and Bequests in Income, 91 HARv. L. REV.1177 (1978); William Klein, An Enigma in the Federal Income Tax: The Meaning of the Word"Gif, "48 MINN. L. REV. 215 (1963); Marjorie E. Kornhauser, The Constitutional Meaning ofIncome and the Income Taxation of Gifis, 25 CONN. L. REV. 1, 28-37 (1992); Lawrence Zel-enak, Commentary, The Reasons for a Consumption Tax and the Income Taxation of Gifts, 51 TAxL. REV. 601, 602-03 (1996).

'SIMONS, supra note 7, at 50. Many provisions of the tax law do not conform to the Haig-Simons definition of income. 'The Haig-Simons definition is sometimes described as an idealto which the tax law can aspire. The characterization of that definition as an "ideal" is notuniversally accepted. Even if one accepts that characterization, there can be competing policiesthat warrant departing from it. The tax law is a pragmatic enterprise that does not operate inisolation of societal and economic events and needs.

'Id. at 50.

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The term "consumption" in the formula refers to personal consumption, ascontrasted to consumption connected with the conduct of a business or theproduction of income. As used in this Article, any reference to "consumption"is to personal consumption. Adopting the definition expounded by ProfessorWarren, consumption generally refers to the "ultimate use or destruction ofeconomic resources."10 Warren defines "economic resources" as the "goodsand services that are generally the subject of market transactions," expresslyexcluding psychic benefits." In general, a person consumes an item or servicewhen it is removed from the societal store of goods and services, and is eitherused up or dedicated to the exclusive use of that person.12

Income tax then is a tax on the taxpayer's current consumption during ataxable year plus the amount of wealth the taxpayer accumulated in that year.The wealth that was accumulated in a taxable year can be seen as representingthe present value of the future consumption that will be purchased with thatwealth. It is assumed that the accumulated wealth will be used for consump-tion at some future date either by the taxpayer or by someone else who subse-quently acquires it. While the proper current taxation of future consumptionmight seem to require a discount of the value of the future consumption toreflect the time gap before it occurs, any discount should be offset by theincome that the taxpayer can earn from the investment of the accumulatedwealth prior to its use for consumption; therefore, it is proper to tax the entireamount of the accumulated wealth without applying a discount. The amountof discount to be applied to future consumption is based on the rate of returnthat the accumulated wealth can produce; consequently, the total amount ofdiscount will equal the total income that the accumulated wealth can pro-duce. The income earned from the investment of the accumulated wealth willgive rise to additional future consumption, so it is reasonable to offset the

"oAlvin Warren, Would a Consumption Tax Be Fairer than an Income Tax?, 89 YALE L.J. 108 1,1084 (1980).

n Id12 1n certain circumstances, a person's use of a resource will be treated as a consumption even

though his use is not preclusive and does not destroy the resource. For example, a person'suse of a software program does not prevent others from using that same program. Why thenshould a payment of a fee to obtain the right to use the program for personal, nonbusinesspurposes be treated as a consumption? It is treated the same as a consumption for tax purposesin that the payment is not deductible even though it reduces the taxpayer's wealth, and so thetaxpayer effectively is taxed on that payment as if it were a personal consumption. Perhaps theanswer is that even though that use does not fit the consumption model, it would contraveneanother tax policy to allow a deduction for a personal expenditure, and so no deduction isallowed. As observed above, the tax law does sometimes depart from the Haig-Simons modelto accommodate other policy objectives. See supra note 8 and accompanying text.


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discount by the income-producing capacity of the accumulated wealth."Thus, the income tax can be seen as a tax on current and future consump-

tion. The reason that consumption has been considered to be the lynchpin ofthe income tax is described in the aforementioned 2003 co-authored article.' 4

At least one commentator rejects the contention that the income tax on accu-mulated wealth is a tax on future consumption and instead maintains that itis a tax on the "power to affect consumption."" Even so, it seems incontro-vertible that the taxation of income is inexorably tied to consumption so thatonce an income tax has been paid on accumulated income, a second incometax should not be imposed when that accumulated income is used to con-sume an item or service.

How then does the relationship of the income tax to consumption affectthe question of whether a gift should be excluded from income? The taxa-tion of future consumption is based on the expectation that the accumulatedwealth will be used for consumption at some time in the future, and it doesnot matter whether it will then be consumed by the taxpayer or by someoneelse.'" This suggests that the taxpayer should be permitted, without incur-ring any additional income tax, either to consume his accumulated wealthhimself or to allow someone else to consume it. The taxpayer should be giventhe widest latitude to obtain the maximum utility from the consumption ofhis accumulated wealth. If a taxpayer can obtain greater utility by vicariouslyenjoying consumption-or his anticipation of the consumption-by some-one of the taxpayer's choosing, then the taxpayer should be allowed to havehis previously taxed wealth so employed.

The reason that a gift is excluded from the donee's income has nothing todo with the merits-or lack thereof-of the donee; rather, it is to allow thedonor to obtain the maximum utility for the consumption of the income onwhich he has been taxed.17 If a gift were subjected to income tax, the con-sumption that could be obtained from the previously taxed income would bereduced, which would conflict with the principle of allowing the after-taxedincome to be consumed in full.

There is an alternative to excluding gifts from income that would also com-ply with the principle of taxing a single consumption only once: The doneecould be taxed on the gift, and the donor could be allowed a deduction for

"Of course, the income from the accumulated wealth is subjected to income tax when

earned. Because the prospective income to be earned from the accumulated wealth has been

taken into account by the tax law in justifying the failure to discount the future consump-tion that will be purchased with that wealth, the income effectively was taxed in the year thatthe wealth itself was accumulated. Taxing the income again when earned is a kind of doubletaxation of the same item. This double taxation of the income from investments creates a bias

against savings in favor of current consumption. The existence of that bias is a factor in why

some persons prefer a consumption tax to the income tax system."Kahn & Kahn, supra note 6, at 454-55."Kornhauser, supra note 7, at 32.'6Kahn & Kahn, supra note 6, at 454.'7 d. at Part I.C.3.


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making it. There is a compelling reason not to take that approach: it wouldundermine progressivity. A high-bracket taxpayer could shift the incidenceof the income tax to a lower bracket taxpayer by making a gift to the lowerbracket taxpayer. The anticipatory assignment of income doctrine is designedto prevent taxpayers from shifting the incidence of the income tax to lowertax bracket persons." Permitting a deduction for a donor would contravenethat policy.

Of course, a gift or bequest may be subjected to a gift or estate tax in somecircumstances, and that imposition will reduce the amount that is availablefor consumption. Obviously, the imposition of transfer taxes conflicts withthe policy of excluding gifts from income. Transfer taxes are independent ofthe income tax and serve different purposes. The point made above is that theincome tax should not interfere with the full use of the after-taxed income forconsumption purposes when the accumulated wealth is transferred to some-one else. Other taxes or costs that may arise are subject to separate consider-ations. It is a matter of Congress's balancing of competing policies. Congressdeemed the policies underlying transfer taxes to be superior to the policy per-mitting a taxpayer the privilege of having another consume his taxed income,so the transfer tax system took priority."

The donor of a gift typically does derive benefits therefrom. The donor canderive pleasure from the satisfaction of seeing the excitement and joy that thedonee displays upon receiving or using the gift. The donor may acquire somemoral suasion that provides him with influence over subsequent choices thatthe donee will make.20 These psychic pleasures are not a financial benefit. Tothe extent that a transfer provides the transferor with a financial benefit, itwill not be a gift for tax purposes. The psychic pleasures that a donor acquiresfrom making a gift do not involve the consumption of any item or servicebecause no societal good or service has been used up. The property transferredby the donor is not consumed until it is either exhausted or dedicated to aperson's exclusive use. If the mere transfer of the property is not a consump-tion, as the Author has concluded, then the donor should be allowed thevicarious enjoyment of having the property consumed by the donee.

It would be an error to equate enjoyment with consumption. While thetwo often go together, neither is a requisite for the other. One can consumean item without deriving any enjoyment from it. For example, X could pur-chase shoes believing that they will serve a useful function. Upon wearingthem, X discovers that they are extremely painful, and so discards them.

His disappointment and failure to obtain enjoyment from the purchase donot prevent it from constituting a consumption. Conversely, X can obtaingreat enjoyment from events that do not constitute a consumption of any

"Id. at Part I.C.7.19Id. at Part I.C.4.

20As King Lear learned to his detriment, the donor is not necessarily able to influence thedonee after the gift is made.


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goods or services. For example, X can enjoy the warmth of the sunshine or thebeauty of a full moon without consuming anything. X can enjoy the companyof a friend or child without consuming anything. Consumption requires thedestruction or preclusive use of property or services. The consumer presum-ably expects to get enjoyment from a purchase, but its consumption does notdepend upon whether he actually does.

Commentators who contend that gifts should be income to the donee havenot asserted that the donor should recognize a gain or loss. 2 1 If the enjoy-ment that the donor obtains is treated as consideration for the transfer, thetransaction would then appear to be an exchange that would be taxable to thedonor as well as to the donee. The value of the consideration received by thedonor could be deemed to be equal to the value of the property the donortransferred, on the assumption that an arm's-length exchange constitutes anexchange of equal values.22 While it is doubtful that many would approve thattreatment, it would seem to follow from the underlying premise of treating agift as income to the donee. For example, if an employer transferred propertyin kind to an employee as payment for services, the employer would recognizegain or loss in the amount of appreciation or depreciation of the transferredproperty. The services the employer received in exchange would be deemed tobe equal in value to the transferred property.

The inappropriateness of treating a donor as recognizing a gain on mak-ing a gift adds strength to the congressional decision to exclude gifts froma donee's income. The difference between a gratuitous transfer of propertyand a payment for a service is striking. If X uses after-tax income to pay Zfor painting X's home, X will have consumed Z's service, and so X will haveobtained the consumption that his prior payment of the income tax entitledhim to. Z will be taxed on the receipt of that payment, and so Z is entitledto use that payment to consume an item or service. There will be two impo-sitions of the income tax, but there will be two consumptions of goods orservices. In contrast, when X makes a gift of property to M, there will be noconsumption of goods or services until M uses it. Between X and M together,there will be only one consumption, and so only one income tax should beimposed.

While the principle of maximizing the taxpayer's options for consumptionsupports the exclusion of gifts from income, there is a conflicting principlepointing toward taxing gifts. Under the Haig-Simons definition of income,the accretion to an individual's wealth should be treated as income regardlessof the source of that income. Commentators who contend that gifts shouldbe income to the donee rely on the Haig-Simons principle.2 3 Because twosignificant principles are in direct conflict with each other, a choice must bemade as to which will be given priority. Congress has consistently chosen to

21 Kahn & Kahn, supra note 6, at n.5.22 See United States v. Davis, 370 U.S. 65, 72 (1962).2 3

SIMoNs, supra note 7, at 56-57, 128.


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prioritize the principle of allowing the donor a wide scope for the consump-tion of taxed wealth, and has exempted gifts from income.24 In the Author'sview, Congress made the correct choice because taxing gifts would be incon-sistent with the current system of taxing accumulated wealth as a surrogatefor taxing future consumption-even though the future consumption maybe enjoyed by someone other than the taxpayer. In any event, it cannot besaid that Congress's choice of one principle over the other is a departure froman ideal tax system; the two principles in question are mutually exclusive andone of them has to give way.

Some commentators who oppose the exclusion of gifts make an excep-tion for gifts to certain family members such as a spouse or children.25 Thisexception is grounded on a view that the taxpayer and a close relative canbe regarded as a single unit for some, but not all, tax purposes. The singleunit concept should not be restricted to family members. If a taxpayer caresenough about someone to permit that person to consume some of the tax-payer's wealth, that circumstance is sufficient to cause the taxpayer and theother person to be treated as a single unit for some limited tax purposes. 26 TheDuberstein standard of resorting to the transferor's intention to determinewhether the transferor made the transfer out of detached and disinterestedgenerosity conforms to the congressional decision to permit the taxpayer tochoose whose consumption would provide the taxpayer with the most utili-

ty.27 All that the donor achieved by making the gift was to permit the doneeto consume the donated property.

In applying the Duberstein standard, courts have indicated that the trans-feror's intention is the exclusive test." While that usually is correct, there aresituations where other considerations should be taken into account. Undernormal circumstances, the congressional choice of elevating the principle ofallowing a taxpayer an expansive range of consumption options over the prin-ciple of taxing accretions to wealth is reasonable. But there are circumstanceswhere the principle of taxing accretion to wealth takes on greater weight andshould be given priority. While no court has expressly adopted that distinc-

24Gifts were excluded from income in the revenue act of 1913 (the first revenue act enactedafter the adoption of the Sixteenth Amendment to the Constitution) and have continued to beexcluded ever since. See Kahn & Kahn, supra note 6, at 442 n.2.

2 5Eg., Dodge, supra note 7, at 1203.26 This view of gifts is buttressed by the manner in which a donee's basis in donated property

is determined. When a gift is made of property in kind, the donee takes the same basis in thedonated property that the donor had at the time of the gift, albeit the donee's basis is modifiedin certain circumstances. I.R.C. § 1015(a). The rationale for that rule is that the donor's basisrepresents the two parties' single investment in the property. See Taft v. Bowers, 278 U.S. 470,482 (1929). The effect of this basis rule is to treat the donor and the donee as a single unit forcertain specified tax purposes. For a more extensive discussion of the single tax unit conceptsee Kahn & Kahn, supra note 6, at 469-74.

27 Commissioner v. Duberstein, 363 U.S. 278, 285 (1960).28See, e.g., Demetree v. Commissioner, 94 T.C.M. (CCH) 126, 2007 T.C.M. (RIA)

1 2007-210.


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tion to modify the Duberstein standard, there are cases where it seems likelythat that was the actual motivation for the court's decision.

One such case is the U.S. Court of Appeals for the Ninth Circuit's decisionin Ok v. United States.29 The taxpayer in Ok was a craps dealer in several LasVegas casinos. The patrons of the casinos used "tokes" (i.e., chips) to maketheir bets. A small percentage of patrons would give a portion of their win-nings to the dealer. No custom existed that would pressure a patron to makethose "gifts," and most did not do so. Under the rules of the casinos, the tokesthat a dealer received were required to be combined with tokes received byother dealers and then divided equally.3 0 The taxpayer had a steady amount ofreceipts from this practice, averaging about $30 a day. The question in litiga-tion was whether the taxpayer's receipt of these tokes constituted income orgifts. The district court made a number of findings; one was that the patronsgave the tokes to the dealer out of detached and disinterested generosity." Thedistrict court held that the tokes were gifts that are excluded from income.32

While the Ninth Circuit properly reversed that decision, its stated ratio-nale was flawed. The court held that the district court's determination of"detached and disinterested generosity" was a conclusion of law to which the"clearly erroneous" standard of review did not apply.33 The Ninth Circuit'sdecision was significantly influenced by the fact that the receipt of the tokeswas regarded by the dealers as a regular part of their compensation.34 Thecourt said,

(m]oreover, in applying the statute to the findings of fact, we are not permit-ted to ignore those findings which strongly suggest that tokes in the handsof the ultimate recipients are viewed as a receipt indistinguishable, exceptfor erroneously anticipated tax differences, from wages. The regularity ofthe flow, the equal division of the receipts, and the daily amount receivedindicated that a dealer acting reasonably would come to regard such receiptsas a form of compensation for his services. The manner in which a dealermay regard tokes is, of course, not the touchstone for determining whetherthe receipt is excludable from gross income. It is, however, a reasonable andrelevant inference well-grounded in the findings of facts.35

29536 F.2d 876 (9th Cir. 1976), cert. denied, 429 U.S. 920 (1976); see also Komjathy v.Adm'r of the Fed. Aviation Auth., 486 U.S. 1057 (1988); Tomburello v. Commissioner, 86T.C. 540 (1986), af'd without published opinion, 838 F.2d 474 (9th Cir. 1993), cert. denied,486 U.S. 1057 (1988); Catalono v. Commissioner, 81 T.C. 8 (1983), af'd without publishedopinion sub. nom. Kroll v. Commissioner, 735 F.2d 1370 (9th Cir. 1984) (holding that chipsreceived by casino employees from patrons of the casinos were income to the recipient).

01k, 536 F.2d at 877.31 Id311d. at 876.

"Id. at 878."Id. at 879.35 d.


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While the Ninth Circuit reached the correct result in Ok, it might bet-ter have grounded its decision on the basis that when a transferee receivesgratuitous transfers from strangers as a regular and anticipated element of hislivelihood, the principle of taxing accretions to wealth takes on greater weightand should be given priority.36 The question of whether those circumstanceswarrant departing from the standard's exclusive reliance on the transferor'sintention did not arise in Duberstein, and so should not be deemed to beforeclosed by the decision in that case.

Consider the following illustration. John, who lost his legs some years ago,is a professional beggar. He occupies a space on a busy street and collects asubstantial amount of donations which constitute his livelihood. John makesno false representations of his condition. The donations he receives are freelygiven by strangers out of detached and disinterested generosity. Should thosedonations be excluded from John's income, or should the fact that he is a pro-fessional donee require that he be taxed on them? In the view of the Author,John should be taxed. Note, however, that an application of an unmodifiedDuberstein standard would treat those donations as gifts and exclude themfrom income.

II. Application of Section 102(a) to Gratuitous Transfers Made to anEmployee

A transfer to an employee for which no property is received in return istypically made to the employee as either compensation for past services, anadvance payment for services to be performed in the future, or a combinationof both. Another possible purpose is to encourage the continued employmentof the recipient of that transfer and of other employees, including prospec-tive employees, who might be induced by that transfer to believe that faithfulservice would, at some future date, net them comparable treatment. Transfersfor any of these reasons would not qualify for an exclusion from incomebecause they are designed to provide an economic benefit to the transferorand so are not made out of "detached and disinterested generosity."

On the other hand, it is possible for an employer to have genuine affectionfor an employee with whom the employer has had significant contact. In somecases, the employee might actually be a member of the employer's family suchas a child or a spouse. A gift to an actual family member should not be recastas compensation merely because the relative happens to be employed by thetransferor. In the more common situation where the employee is not actually

6The Ok case is discussed in greater depth in Kahn & Kahn, supra note 6, at 476-82.A different treatment of regular transfers to an individual is warranted when the parties are

related or have a relationship in which persons customarily make gifts. So, for example, if an

adult child were to live off of an allowance provided by his parent, the allowance should be

excluded from income as a gift. This is one of the circumstances in which the tax treatment of a

transfer can be influenced by the relationship of the transferor to the transferee. As we shall see,

another circumstance in which the parties' relationship is a relevant factor is when an employer

transfers property to an employee.


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related to the employer, their relationship might grow to the point where theemployer regards the employee as an informal member of his family. In suchcases, just as can be the case when the employee is an actual relative, a transferto the employee might be made out of affection rather than as compensation.While such friendships arise more frequently in cases of household employ-ment, they can also occur when an employee, who is employed by a smallbusiness, works closely with the owner.

This Part examines how the exclusion provision of section 102(a) appliesto lifetime and testamentary transfers to an employee without regard to theapplication of section 102(c). Part III examines the application of section102(c). The question of how a testamentary transfer to an employee shouldbe treated invokes different considerations than those that apply to inter vivostransfers, and so the two situations are examined separately.

A. Inter Vivos Transfers to an Employee

In the Duberstein case, the government proposed a standard for determin-ing what constitutes a gift that would have ruled out gift treatment for mosttransfers from employers to employees.3 7 As reported by the Court, the gov-ernment contended that voluntary payments to an employee ought to be "byand large" taxable.38 As so stated, it seems that even the government acknowl-edged that there are circumstances where a transfer to an employee might be agift. In any event, the Court rejected the government's position and expresslyrefused to adopt a bright-line standard for determining what constitutes agift. Instead, the Court held that the intention of the transferor in makingthe transfer is the crucial determinant." The voluntariness of a transfer isnot sufficient to make it a gift. To be a gift, the transfer must proceed out ofthe transferor's detached and disinterested generosity. The transfer should bemade out of "respect, admiration, charity or like impulses."40 If the transf-eror's incentive was to obtain an economic benefit, the transfer would not bea gift.

The Duberstein standard is typically stated as requiring "detached and dis-interested generosity" for the transfer to qualify as a gift, and that phrase isfrequently used in this Article. However, the reader should keep in mindthat the phrase itself is not that helpful in resolving gift issues. To apply theDuberstein standard, it is necessary to understand what types of transfer pur-poses are embraced within the phrase "detached and disinterested generosity,"and how those purposes interact with the facts of each situation. The EighthCircuit expressed its doubts as to the usefulness of that phrase as follows:

17The standard proposed by the government was that "[g] ifts should be defined as transfers

of property for personal as distinguished from business reasons." Commissioner v. Duberstein,363 U.S. 278, 284 n.6 (1960).

31d. at 287.

39Id. at 285-86 (quoting Bogardus v. Commissioner, 302 U.S. 34, 43 (1937))."od. at 285 (quoting Robertson v. United States, 343 U.S. 711, 713-14 (1952)).


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Many courts nevertheless give talismanic weight to a phrase used more casu-ally in the Duberstein opinion-that a transfer to be a gift must be the prod-uct of "detached and disinterested generosity." . . . [I]t is the rare donor whois completely "detached and disinterested." To decide close cases using thisphrase requires careful analysis of what detached and disinterested means indifferent contexts. Thus, the phrase is more sound bite than talisman.'

In Duberstein, the Court noted that if a transfer was made in return forservices rendered, it would not be a gift even if the transferor derived noeconomic benefit from making the transfer.42 Thus, tips given to a serviceprovider are income to the recipient.4 3 The line between compensating anemployee for past services, and making a gift in gratitude for the loyal andfaithful service that an employee had provided, rests on making a difficult,subtle, and fine distinction. That difficulty was eliminated by the 1986 addi-tion of section 102(c); the legislative history establishes that an employer'sappreciation of an employee's service does not establish the type of relation-ship that prevents the application of that provision." There is reason to ques-tion whether, as a matter of policy, a transfer proceeding from gratitude foran employee's service should be taxed differently than compensation for pastservice, and section 102(c) treats them the same.

The Court held that the test of "detached and disinterested generosity"is a factual question so that each case must be resolved on the basis of thefacts presented." While the Court recognized that transfers made in a busi-ness context usually will not be gifts, the Court also recognized that humanrelationships are complex and diverse, and that there are circumstances wheresuch transfers will be made primarily out of detached and disinterested gen-erosity.46 The Court's decision in Duberstein involved two separate cases thatwere consolidated for the Court's review. It is instructive to see how the Courtdealt with each of those cases.

In Duberstein, the taxpayer, who was president of one corporation, hadhad business dealings with the president of an unrelated corporation.47 Fromtime to time, the taxpayer had voluntarily given the other president names ofclients for the other company to solicit, and the taxpayer had neither soughtnor expected compensation for doing so. In appreciation of what the tax-

4'Goodwin v. United States, 67 F.3d 149, 152 n.3 (8th Cir. 1995).42363 U.S. at 285 (quoting Robertson v. United States, 343 U.S. 711, 714 (1952)).43Reg. § 1.61- 2 (a)(1). Indeed, the Supreme Court expressly stated that tips are income in

footnote seven of the Duberstein decision. 363 U.S. at 285 n.7. The Tax Court has approveda formula for estimating the amount of an employee's tip income, sometimes referred to asthe "McQuatters Formula." See McQuatters v. Commissioner, 32 TC.M. (CCH) 1122, 1973TC.M. (RIA) 1 73,240.

"See the quote from the House Report to the 1986 Act in the text accompanying note 85,infra.

"Duberstein, 363 U.S. at 285, 288-90."Id. at 287.1

7Id. at 280.


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payer had done, the other corporation "gave" the taxpayer an automobile.The Tax Court upheld the Commissioner's determination that the receipt ofthe automobile was income to the taxpayer." The Court of Appeals for theSixth Circuit reversed and treated the receipt as a gift." The Supreme Courtreversed the Sixth Circuit and held that the factual determination of the TaxCourt was conclusive because it could not be said to be clearly erroneous. 0

In Stanton, the other case consolidated before the Court in Duberstein,an officer of a corporation received a gratuity from his employer upon hisretirement.5' The district court, sitting without a jury, found that the pay-ment of the gratuity was a gift. 52 The district court did not make any findingsas to the facts on which it based its conclusion. The Court of Appeals for theSecond Circuit reversed." The Supreme Court reversed the Second Circuit,but sent the case back to the district court for more explicit findings.54 It isnoteworthy that the Court left open the possibility that the payment of thegratuity would be treated as a gift, even though it was made by an entity to anemployee. It is also noteworthy that on remand, the district court again heldthat the taxpayer's receipt of the gratuity was a gift, and the Second Circuitaffirmed that decision.55

In the majority of circumstances, an uncompensated transfer of propertyto an unrelated employee will be income to the latter.5' Notwithstanding thegift treatment applied in Stanton, even if the payment is made to a retiredemployee, and even when made prior to the adoption of section 102(c), thepayment was often included in income. 7 While the transferee is no longeremployed when the payment is made, the payment could be for past servicesperformed when the transferee was an employee. While there are only a fewauthorities subsequent to Duberstein that dealt with retirement payments,58

"Id. at 281.49Id.51d. at 291-92."Id. at 281-82.52d. at 278, 283.53Id.5Id at 278, 293."Stanton v. United States, 186 E Supp. 393 (E.D.N.Y. 1960), aft'd, 287 F.2d 876, 877 (2d

Cir. 1961).'Duberstein, 363 U.S. at 287.

"See infra note 59."Since 1986, the issue typically will be resolved by applying section 102(c), and so the

question of whether the payment would have qualified under the Duberstein standard will ariseinfrequently. But see Goodwin v. United States, 67 E3d 149 (8th Cir. 1995) (a post-1986 caseinvolving transfers to an employee that was decided on the Duberstein standard rather thansection 102(c)).


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the weight of those authorities favors taxing them." However, there are cir-cumstances where the Duberstein standard is satisfied.

Under what conditions will a payment to an employee qualify as a gift

under the Duberstein standard? In the view of the Author, to conclude that a

transfer proceeded from detached and disinterested generosity, all of the fol-

lowing five conditions have to be satisfied in order to negate an inference of

compensatory purpose:

(1) The employer obtained no economic benefit from making the transfer.

(2) There was a personal relationship between the employer and employeeof such nature that it would not be unusual for a gift to be made-that is,their relationship is one in which a transfer of property might well be madeout of detached and disinterested generosity. While it might be possible foran entity to have such a relationship with an employee through the entity'schief officer or principal owner, it is more likely that a relationship of sucha nature will occur between two individuals.60 As noted in Part III, it willnot be possible to avoid the application of section 102(c) to a transfer froman entity to its employee.

(3) The occasion for making the transfer was either an event where gifts arecustomarily made, such as a birthday, a marriage, an anniversary, or a gradu-ation, or the employee had a financial need that would arouse the sympathyor concern of the employer.

(4) The actual compensation paid to the employee was reasonable whencompared with compensation paid to persons who perform comparablework for others or for the employer.

59 See, e.g., Nattrass v. Commissioner, 33 T.C.M. (CCH) 1389, T.C.M. (P-H) 1 74,300(1974); Rev. Rul. 1976-516, 1976-2 C.B. 24; Rev. Rul. 1972-342, 1972-2 C.B. 36 (tax-ing payments to a retired employee); see also Estate of Sweeney v. Commissioner, 39 T.C.M.(CCH) 201, TC.M. (P-H) 79,201 (1979).

On the other hand, Brimm v. Commissioner, 27 T.C.M. (CCH) 1148, T.C.M. (P-H)68,231 (1968), treated a voluntary payment from an employer as a gift when a school that

had ceased operations made payments to all of its professors. The payments were made pur-suant to a "severance policy" that the school's trustees adopted. While the result in Brimm isquestionable, the court was likely influenced by the fact that, because the employer terminatedits business, the purpose of the payment could not have been to provide an inducement for theemployee, or any other employee, to continue working for that employer. However, Nattrassalso involved a payment from an employer that had terminated its business, and the Tax Courtheld that the payment was income to the employee. 33 T.C.M. (CCH) at 1389, T.C.M. (P-H)

74,300 (1968)."However, there are pre-section 102(c) cases in which transfers from an entity to an

employee were held to be gifts. One such case is the district court and court of appeals decisionin Stanton, 287 F.2d 876 (E.D.N.Y. 1960), on remand from the Supreme Court. Stanton is oneof the two consolidated cases that comprised the Duberstein decision in the Supreme Court.In Estate of Carter v. Commissioner, 453 E2d 61 (2d Cir. 1971), the Second Circuit held that acorporation's payment to the widow of a deceased employee was a gift. Another case in whichan entity's transfer to an employee was held to be a gift is Brimm, 27 TC.M. (CCH) 1148,

T.C.M. (P-H) 1 68,231 (1968).


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(5) The payment was not pursuant to a contract, past practice, or an under-standing that was designed to induce the employee to provide services.This requirement is not violated merely because an employer who has therequired relationship with the employee had informed the employee thathe will make a gift on an appropriate date such as Christmas, a birthday, oran anniversary; nor is it violated by a practice of making gifts on those orsimilar dates. It is only when the purpose of informing the employee or ofhaving a practice of making gifts is to encourage the employee to continuein the employer's service that the requirement is violated."1 This is a subjec-tive test.

Part III considers whether there are any exceptions to the blanket rule of sec-tion 102(c) and, if there is an exception, to what extent its requirements differfrom the five conditions listed above.

A more difficult question arises when an employee dies and the employermakes a payment to the employee's widow or other family member. The pay-ment is not made to or on behalf of a current employee, but it is made withrespect to a prior employee. Part III will consider whether section 102(c)applies to such payments. If there was a preexisting agreement, understand-ing, or plan that a payment would be made on the employee's death, thepayment would be income to the recipient.6 2 In such circumstances, the pay-ment that was made after the employee's death would appear to be deferredcompensation. But how should death benefits be treated when there was nopreexisting plan, practice, or agreement?

Prior to the Duberstein decision, death benefits often were excluded fromincome as gifts. 3 After Duberstein was decided, the Tax Court generally helddeath benefits to be income unless unusual circumstances indicated that thepayments were motivated by compassion." Several of those Tax Court deci-sions were reversed.65 District courts applying the Duberstein standard, how-ever, were more open to finding that death benefit payments qualified as giftsif not made pursuant to a plan (formal or informal) or a preexisting policy.'

In many cases, a death benefit will be made pursuant to an agreement or

61 Cf Roberts v. Commissioner, 69 TC.M. (CCH) 2409, 1995 T.C.M. (RIA) 1 95,171.62 See Meyer v. United States, 244 E Supp. 103 (S.D. Cal. 1965); Landry v. United States,

227 E Supp. 631 (E.D. La. 1964); McCarthy v. United States, 232 E Supp. 605 (D. Mass.1964); Estate of Hellstrom v. Commissioner, 24 TC. 916, 920 (1955). If the recipient of thepayment has a significant ownership interest in the employer entity, the payment likely willbe treated as income. See Dickson v. Commissioner, 23 T.C.M. (CCH) 1161, T.C.M. (P-H)

64,191 (1964).6 BORIus 1. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES AND

Gwrs 1 10.2.4 (3d ed. 1999)."Estate of Carter v. Commissioner, 453 E2d 61, 66-67 (2d Cir. 1971); BITrKER & LOK-

KEN, supra note 63.65See, e.g., Estate of Kuntz v. Commissioner, 300 F.2d 849 (6th Cir. 1962), cert. denied, 371

U.S. 903 (1962); Estate of Olsen v. Commissioner, 302 E2d 671 (8th Cir. 1962), cert. denied,371 U.S. 903 (1962).

'See, e.g., Waters v. Commissioner, 48 E3d 838, 850 (1995).


286


pattern of practice. As noted above, in those cases, the benefit usually washeld to be taxable.17 However, if there was no prior practice or agreement, andif the surviving family is destitute or has financial needs that elicit sympathy,the death benefit should qualify as a gift under the Duberstein standard evenwhen the employer is an entity.'6 In addition, if there was a personal rela-tionship between the employer and the deceased employee, the death benefitmight be found as a fact to be motivated by affection or compassion.

In sum, a voluntary payment to an employee, or to the family of a deceasedemployee, can qualify as a gift if there is a finding that the Duberstein stan-dard was satisfied and if the facts negate the inference that the payment wascompensatory.

B. Testamentary Transfers to an Employee

If an employer dies and leaves a bequest to an employee, and if there wasno prior agreement that the employer would make that bequest if serviceswere performed by the beneficiary, the bequest will qualify for exclusion fromincome under section 102(a).6'9 In such circumstances, the bequest obviouslywill not serve to induce the beneficiary to remain in the decedent's employ,and so that aspect of inter vivos gifts does not apply to testamentary transfers.However, a bequest might be made in satisfaction of a promise that was givento the employee to induce the latter to provide services during the decedent'slife; such a bequest should be considered compensation for past services. Ifservices were provided to the decedent in reliance on the decedent's prom-ise to bequeath property to the service provider, the bequest is compensa-tion to the beneficiary and should be included in the latter's income.70 Whilethe cases that have dealt with this issue involved enforceable agreements, abequest made pursuant to an unenforceable understanding also should beincluded in income if the decedent's purpose in entering that agreement wasto induce the employee to perform services.

The characterization for federal income tax purposes of the receipt of prop-erty under a valid settlement of a will contest is a federal question.7' The

67See id.65Estate of Carter held that a corporation's payment to the widow of a deceased employee

was a gift. 453 E2d at 66-67.6

1McDonald v. Commissioner, 2 T.C. 840 (1943); Jones v. Commissioner, 23 T.C.M.(CCH) 235, TC.M. (P-H) 1 64,039 (1964); see also Estate ofTebb v. Commissioner, 27 TC.671 (1957), acq. 1957-2 C.B. 7. The beneficiaries in Tebb were children of the decedent, andthere was an agreement that they would continue to work for the family's corporation. Thecourt found that the decedent had expressed the wish to bequeath the property to them regard-

less. Tebb, 27 T.C. at 677. The decision for the taxpayer is questionable.7oWolder v. Commissioner, 58 TC. 974 (1972), afd, 493 E2d 608 (2d Cir. 1974), cert.

denied, 419 U.S. 828 (1974); Braddock v. United States, 434 E2d 631 (9th Cir. 1970); Millerv. Commissioner, 53 T.C.M. (CCH) 962, T.C.M. (P-H) 87,271 (1987); Rev. Rul. 1967-375, 1967-2 C.B. 60. But see Roberts v. Commissioner, 69 T.C.M. (CCH) 2409, 1995 T.C.M.(RIA) 95,171.

7'Lyeth v. Hoey, 305 U.S. 188, 193 (1938).


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SECTION OF TAXATION

characterization depends upon the nature of the claim and the settlement.7 2

The crucial question is, what was the settlement amount paid in lieu op Ifthere is a valid claim for inheritance, such as a claim based on the contentionthat a will was made under undue influence, the receipt of the property willbe treated as a bequest that is excluded from income.7 1 This rule is necessaryto prevent tax consequences from deterring settlements of will disputes. Ifthe plaintiffs claim is based on an agreement with the decedent to bequeathproperty if services were provided or if the claim is for quantum meruit, thenthe property should be taxable. Notwithstanding how such claims should betreated, the courts and the Service have sometimes excluded such settlementsfrom income.

One case that demonstrates the difficulty of predicting the outcome oflitigating that issue is the Tax Court's 1995 memorandum decision in Robertsv. Commissioner.7 1 In the Roberts case, Mildred agreed to leave her job andhome in Ohio, and come to live with Elmer in North Carolina. Elmer wasvery ill, and Mildred cared for him for over eight years until he died. Elmerpromised Mildred that he would leave her specified amounts and properties.Mildred loved and trusted Elmer. While she and Elmer discussed marriage,they never married. Mildred was treated by Elmer and his sisters as a memberof their family. While Elmer's final will bequeathed property to Mildred, itwas considerably less than he had promised her. Mildred filed a claim againstthe estate on the alternative grounds of breach of contract or for servicesrendered. The claim was settled for $50,000, and the settlement agreementstated that the settlement amount was one of the benefits conferred uponMildred by the will. The Tax Court held that since the settlement agreementcharacterized the settlement as an amount due under Elmer's will, the amountMildred received constituted a bequest for federal income tax purposes andwas not taxable.7

1 The holding in that case seems to be incorrect, but the tax-payer did present a sympathetic figure. A number of cases and rulings in thisarea are irreconcilable.77 Part III considers whether the adoption of section102(c) clarifies the treatment of gifts and bequests to an employee, former

72 d

73Id."See Green v. Commissioner, 54 T.C.M. (CCH) 764, T.C.M. (P-H) 5 87,503 (1987), afd,

846 F2d 870 (2d Cir. 1988), cert. denied, 488 U.S. 850 (1988).7 569 T.C.M. (CCH) 2409, 1995 T.C.M. (RIA) 95,171. For a similarly liberal exclusion of

a settlement based on a contractual agreement for services of the taxpayer's spouse, see P.L.R.2001-37-031 (Sept. 14, 2001). The taxpayer's spouse had ceased to be employed for sometime before the claim was made, so there is a question whether section 102(c) was applicable,but the Service did not even consider whether section 102(c) applied. See also Estate of Tebbv. Commissioner, 27 T.C. 671 (1957), acq. 1957-2 C.B. 7, where a bequest was excluded fromincome even though there was a prior agreement for the receipt of services.

76Roberts v. Commissioner, 69 T.C.M. (CCH) 2409, 1995 T.C.M. (RIA) 95,171.n"Compare id, and Estate of Tebb v. Commissioner, 27 T.C. 671 (1957), acq. 1957-2 C.B.

7, with Green v. Commissioner, 54 T.C.M. (CCH) 764, T.C.M. (P-H) 1 87,503 (1987), afd,846 F.2d 870 (2d Cir. 1988), cert. denied, 488 U.S. 850 (1988).


288


employee, or relative of a former employee.While, for a bequest to be excluded, there should be a requirement that the

employer and the employee had a personal relationship, that relationship isvirtually certain to have existed when an employer bequeaths property to anemployee without there being an agreement for him to do so. Consequently,that requirement will not likely be an issue in testamentary cases. The mostcommon circumstance in which a bequest is made to an employee is wherethe beneficiary was a household employee who had worked for the decedentfor many years. Even though a household employee might have an expec-tation of receiving a bequest in that circumstance, the employee's expecta-tion is no different than the expectation a child of the decedent might have.A household employee who has developed a personal relationship with hisemployer after serving the employer for a number of years may have becomean unofficial member of the employer's family. While that family-type rela-tionship can arise in other long-term employment relationships, they likelyoccur more frequently in connection with household employment.

III. The Application of Section 102(c)

As previously noted, subsection (c) was added to section 102 in 1986. Section102(c) provides that section 102(a) "shall not exclude from gross incomeany amount transferred by or for an employer to, or for the benefit of, anemployee."7 The legislative history for this provision is sparse but does pro-vide some guidance.

The provision was added to the Code by section 122(b) of the Tax ReformAct of 1986 (Act) .7 The title to section 122 of the Act is "Prizes and Awards."Employees can receive awards from their employer for accomplishmentssuch as length of service or excellent conduct of their work."o In discussingthe adoption of the section 102(c) provision, the House Report, the SenateReport, and the Conference Report to the Act all focus on employee awardsand state that the addition of that provision means that it will no longer bepossible to exclude such awards as gifts."

Congress did not want the Duberstein standard to be applied to employeeawards and chose a bright-line rule that prevented exclusion as a gift. Congressdid note that an employee award might be excludable under some other stat-utory provision, such as a de minimis fringe benefit under section 132(e), oras an award under section 74(b) that the employee turned over to a qualifiedcharitable organization. 82

781.R.C. § 102(c).79Tax Reform Act of 1986, Pub. L. No. 99-514, § 122(b), 100 Stat. 2085, 2110.8 d. § 122(d), 100 Stat. at 2 11 1.1H.R. REP. No. 99-426, at 103-06 (1985); S. REP. No. 99-13, at 47-51 (1986); H.R.

REP. No. 99-841, pt. II, at 17-19 (1986) (Conf. Rep.)."See sources cited supra note 81.


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SECTION OF TAXATION

While employee awards were the focus of the Act, the scope of section102(c) is not limited to awards. Let us now consider the application of thatprovision-first to inter vivos transfers and then to testamentary transfers.

A. Inter Vivos Transfers to an Employee

In adopting section 102(c), Congress intended to prevent gift treatment foremployee awards regardless of whether the Duberstein standard could bemet.83 If such an award is to be excluded, it will have to fit under some otherstatutory provision. But what about transfers to an employee that do not con-stitute awards? The unrestricted language of the statute denies gift treatmentto any transfer from an employer to, or for the benefit of, an employee.14 It isreasonably clear, however, that notwithstanding that language, Congress didnot intend to prevent gift treatment for all such transfers. The House Reporton the 1986 Act states,

[o]f course, gifts between individuals made exclusively for personal reasons(such as birthday presents) that are wholly unrelated to an employment rela-tionship are not includible in the recipient's gross income merely becausethe gift-giver is the employer of the recipient. A transfer between personalacquaintances will not be considered to have been made exclusively for per-sonal reasons if reflecting any employment-related reason (e.g., gratitude forservices rendered) or any anticipation of business benefit. 5

In addition to this statement in the House Report, a proposed regulationwas promulgated on January 9, 1989, adopting a similar construction of sec-tion 102(c). The proposed regulation states,

[f]or purposes of section 102(c), extraordinary transfers to the naturalobjects of an employer's bounty will not be considered transfers to, or forthe benefit of, an employee if the employee can show that the transfer wasnot made in recognition of the employee's employment. Accordingly, sec-tion 102(c) shall not apply to amounts transferred between related par-ties (e.g., father and son) if the purpose of the transfer can be substantiallyattributed to the familiar relationship of the parties and not to the circum-stances of their employment."

"See sources cited supra note 81.8

4 I.R.C. § 102(c).81H.R. REP. No. 99-426, at 106 n.5 (1985).1

6Prop. Reg. § 1.102-1(f)(2), 54 Fed. Reg. 627 (1979). While it has been more than 30years since the proposed regulation was adopted, and it has not yet been finalized, it is a sen-sible construction of the statute and generally conforms to the House Report on that provi-sion. For a possibly contrary view see Williams v. Commissioner, 2005-1 U.S.TC. ! 50,163,95 A.F.T.R.2d 764 (10th Cir. 2005). Williams could have been resolved on the basis that thepayment was made by a corporation (i.e., an entity) to its employee, but the court discussedthe issue as if the payment had been made by a shareholder of the corporation. The opinion inWilliams is somewhat confusing, and it is understandable that it was not selected for publica-tion in the Federal Reporter. The case is discussed infa note 97.


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While Proposed Regulation section 1.102-1(f) (2) is more restrictive thanthe House Report, both pronouncements construe section 102(c) as not pre-venting gift treatment for some transfers to an employee. The gist of the pro-posed regulation and the quoted footnote from the House Report is that anindividual can occupy more than one relationship with another person. Anemployee can have both a business relationship and a personal relationshipwith an individual who is his employer. If an individual makes a transfer toan employee, there must be a determination as to whether the transfer wasmade to the transferee in his capacity as an employee, or as a personal friendor relative. Section 102(c) applies only if the transfer was made to the trans-feree in his capacity of being an employee.17 Even if section 102(c) does notapply, however, the transfer will still not be treated as a gift unless the transfersatisfies the Duberstein standard.

The same five requirements for applying the Duberstein standard to trans-fers from an employer to an employee that the Author proposed in Part II ofthis Article should also be conditions that must be satisfied to prevent section102(c) from applying. While this might suggest that section 102(c) did notchange much from the Duberstein standard, that is not true. It is more dif-ficult to escape from section 102(c) than to satisfy the Duberstein standard.The statute covers employee awards, whereas previously they were sometimestreated as gifts. It is more difficult to demonstrate that an employer's transferto an employee had no connection with the employment relationship than toestablish that the principal purpose of a transfer was personal. The Dubersteinstandard rests on the transferor's principal purpose. As discussed below, prin-cipal purpose likely is not adequate to escape section 102(c)-a more strin-gent requirement applies. Also, as discussed below, a transfer from an entityto an employee cannot qualify as a gift under section 102(c).

The statement in the House Report precludes section 102(c) treatment ifthe transfer between individuals was made exclusively for personal reasons,and suggests two limitations on the exclusion from the statutory provision."One is that the statute will apply to prevent gift treatment if the transferor isan entity, since the exclusionary language of the House Report is restrictedto transfers between individuals. The Author will address that issue later. Thesecond is that the transfer must be made exclusively for personal reasons. Onemight question whether that latter requirement is too restrictive. Considerthe following illustration:

G has been employed for 20 years in F's household to provide domesticservices. In addition to her salary, G has occupied a room in F's home andhas come to be regarded as part of the family. G is stricken with an illnessthat requires several years of expensive medical treatment. G's insurance willnot pay for the treatment, and G lacks the funds to pay for it. F volunteersto pay for G's treatments. F's reason for doing so is his compassion for

"See H.R. REP. No. 99-426 (1985).881Id.


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G's plight and his family's affection for her. However, F is also aware thatthe payment will induce G to remain in F's employment, and F regardsthat inducement as an additional benefit from making the contribution. Fwould have paid G's medical expenses even if G's medical condition wouldhave prevented her from continuing to work. The fact that F had a minorcompensatory purpose that did not influence F's decision to pay the medi-cal expenses should not taint those payments.

Indeed, there likely will be a nonpersonal benefit of some nature in virtu-ally every transfer to an employee, and so a requirement of exclusivity wouldmake the exception to section 102(c) meaningless. A requirement of exclusiv-ity is overly restrictive and should not be adopted.

Instead of an exclusive requirement, a primary purpose standard could beadopted, but that is too liberal. An objection to a primary purpose standardis that it impairs one of the objectives of section 102(c) to minimize the needto make difficult subjective determinations in order to ascertain whether thegift exclusion is applicable. Rather than requiring a weighing of several dif-ferent purposes against each other, a more restrictive and administrativelyconvenient requirement could be imposed. Instead of a primary purpose test,a taxpayer should be required to show that a personal purpose was both nec-essary and sufficient for the transfer to take place-that is, that the transferwould not have been made but for personal reasons, and that the transferwould have been made even if there had been no nonpersonal reasons for it.While that test also requires making judgments about the transferor's subjec-tive motivation for making the transfer, a more restrictive standard shouldresult in fewer cases where that issue would be close enough to be put intodispute. Moreover, a necessary and sufficient standard would preclude section102(c) only when a nonpersonal benefit to the transferor had no effect on thedecision to make the transfer. That latter aspect of a necessary and sufficientrequirement is better attuned to the peremptory language of the statute.

Another question is whether an employer that is an entity can make a giftto an employee. As noted above, the statement from the House Report sug-gests that it cannot." That seems an appropriate conclusion because the con-cept of a personal, nonbusiness relationship does not apply to the relationshipbetween an entity and an individual.

While it appears an entity cannot make a gift to an individual employee, isit possible to reconstruct a transfer of property from an entity to an employeeas a gift from an individual owner of the entity? For example, could a transferto an employee from a closely held corporation or partnership be treated as atransfer from an individual shareholder or a partner? That approach would bean application of the substance versus form doctrine. If the facts indicate thatthe gift actually comes from an individual owner who has a personal reasonto make the gift, it might seem that gift treatment should not be denied justbecause the assets of the entity were employed. However, that treatment of

89Id.


292


the transaction creates tax consequences that can significantly complicate thesituation and so perhaps should be applied sparingly if at all. If the transferof an entity's assets are deemed to have been made by an owner of the entity,then there should be a constructive distribution of the transferred assets tothe owner, followed by a gift by the owner to the employee. The construc-tive distribution to the owner creates tax consequences and can raise difficultissues to resolve.

Let us first assume that the entity is a corporation with a sole individualshareholder who has a personal reason to make a gift to the employee. Aconstructive distribution of the transferred amount to the shareholder willcause the shareholder to have dividend income to the extent that the corpo-ration has earnings and profits. 0 The constructive transfer of the propertyfrom the shareholder to the employee will be treated as a gift." Even thoughthat treatment does not cause undue complications, it should not be adoptedunless the same approach will be applied when the corporation has multipleshareholders. If the constructive distribution approach causes too much com-plexity when there are multiple owners of the entity to apply the approach inthose cases, then it would be better not to apply a constructive distributionapproach even when there is a sole shareholder. It would be difficult for theService or the courts to fashion a rule that would apply constructive distri-butions only when there is a single owner unless that rule were adopted byCongress as a statutory provision.

Now, let us assume that the corporate entity has three equal shareholders:A, B, and C. C has a personal reason to make a gift to the employee, but Aand B do not. If the corporation's transfer of property to the employee is to betreated as a constructive distribution to the shareholders, which shareholderswill be deemed to have received that constructive distribution? If each of theshareholders is deemed to have received one-third of the property transferredto the employee, and then transferred his share to the employee, the problemis that only C has a personal relationship with the employee that will qualifyhis constructive transfer as a gift. The constructive transfers by A and B wouldbe deemed to have been made "for" the entity and would not qualify for gifttreatment. If so construed, that would possibly require A and B to recognizedividend income, and the employee would still be taxed on two-thirds ofthe transfer he received. Rather than adopting such a complex and tax-costlyconstruction, it would seem better to just treat one-third of the transferredproperty as having come from C, and the remaining two-thirds as havingcome from the entity. The employee would then be taxed on two-thirds of theproperty he received, but only C would have constructive dividend income.

Another possibility is to construe the transaction as a constructive distribu-tion of 100% of the transferred property to C, followed by a gift from C tothe employee. All of the dividend treatment would then fall on C, and the

9oI.R.C. %§ 301(c)(1), 316(a). The corporation will not recognize income. I.R.C. § 311(a).9 1See H.R. REP. No. 99-426 (1985).


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employee would have no income. The problem is that A and B have a right toshare in the corporation's distributions, and their failure to exercise that rightcould cause each of them to have a constructive dividend of one-third of theamount transferred, followed by a constructive transfer from them to C.92

Even though A and B are subject to taxation from their waiver of a dividenddistribution, it is possible that the Service would not seek to impose dividendtreatment on them; however they would be vulnerable to that treatment.

If the entity that makes the transfer is a partnership, a constructive distri-bution to the partners usually will not cause them to recognize income.9 Apartner will recognize a gain from receiving a distribution from the partner-ship only to the extent that cash and marketable securities that the partnerreceived exceed the partner's basis in his partnership interest." However, adistribution will reduce both a partner's basis in his partnership interest" andhis capital account.96 As with corporations, when there are multiple partnersthere is an issue as to how the constructive distributions should be allocatedamong them.

Currently, there is no authority treating an entity's transfer to an employeeas a constructive distribution to the owners of the entity, followed by a gift ofthat constructive distribution to the employee. Given the complications suchtreatment can cause, it might be better not to apply that approach. Instead,the constructive distribution approach should be restricted to transactionswhere there is clear evidence that one or more of the owners of the entity arethe true donors of the property. 7

Proposed Regulation section 1.102-1(f)(2) states that extraordinary trans-fers to the natural objects of an employer's bounty will not be subject to sec-tion 102(c).9 ' While the second sentence of the regulation refers to transfersbetween related parties, that is just an example of persons who could be thenatural object of the transferor's bounty.9 The exception is not limited to

92Rev. Proc. 1967-14, 1967-1 C.B. 591.

"I.R.C. § 731(a)(1). The partnership will not recognize income. I.R.C. § 731(b)."I.R.C. § 731(a)(1).11I.R.C. § 732.96Reg. § 1.704-1(b)(2)(iv)(b).97See Williams v. Commissioner, 2005-1 U.S.T.C. 1 50,163, 95 A.F.T.R.2d 764 (10th Cir.

2005), where payments from a corporation to an employee were included in the employee'sincome. The employee had a close, personal relationship with the president of the corpora-tion-who also was one of its two shareholders. Ignoring the entity aspect of the payment,the court discussed the issue as if the payment had been made by the shareholder and as if theshareholder were the employer. The court did not consider what the ramification would be ofhaving a payment by the corporation treated as a transfer by a shareholder. While the court'sopinion is confusing, it does suggest that a close relationship between an employer and anemployee does not prevent the application of section 102(c). The court also seemed to holdthat the payment in question did not qualify as a gift without regard to whether section 102(c)applied. Id There seems to be ample justification for the decision not to have the opinionpublished in the Federal Reporter.

"Prop. Reg. § 1.102-1(f)(2), 54 Fed. Reg. 627 (1979).99Id.


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related parties. Whether an individual is the natural object of a transferor'sbounty depends upon their actual relationship rather than on their kinship.An individual might dislike a relative and adore an unrelated individual. Itis a subjective test. Note also that there is no mention of related parties inthe House Report, which requires only that the gift be made exclusively forpersonal reasons."

One might question whether the proposed regulation's use of the word"extraordinary" makes that an additional requirement. The regulation doesnot explain what is meant by that word. The term is not used in the HouseReport. It is reasonable to conclude that either there is no requirement thata transfer be extraordinary (particularly because the House Report makes nomention of it), or that it means only that the transfer not have a compensa-tory or business purpose. Instead, the term could mean that a series of trans-fers cannot qualify and that only an isolated transfer can qualify. But there isno sensible reason for imposing that requirement. For example, employer Hmakes annual gifts to employee K, who is H's daughter, every Christmas andevery birthday. Such gifts might not be deemed extraordinary because they aremade regularly every year. There is no reason, however, to deny gift treatmentto those gifts merely because they are not isolated transactions. Moreover,the House Report gives "birthday presents" as an example of transfers thatqualify. The Report's use of the plural "presents" suggests that multiple giftscan qualify.' The crucial question should be whether the transfer is made tothe transferee in their capacity as an employee or in some other capacity. Thenumber or size of the transfers may be of evidentiary value, but they are notbright-line designators.

Should a series of transfers that are made to assist an employee who is indire financial condition be classified as extraordinary? Earlier, this Article ref-erenced a situation where an employer paid the medical bills of a long-timeemployee who needed medical care that she could not afford. There is noreason to deny gift treatment just because payments were made periodicallyover some time. A series of payments might raise an inference that they arecompensatory, but the taxpayer should be allowed to rebut that inferencewhen the facts indicate a noncompensatory purpose.

Can section 102(c) apply to an employer's payment to a family memberof a deceased employee-so-called death benefit payments? Part II discussedwhether death benefit payments could qualify as gifts under the Dubersteinstandard and concluded that they could if the payments were not made pur-suant to a contract, agreement, or practice of the employer. A death benefitpayment is not made to an employee. However, the statute also applies totransfers made "for the benefit of an employee."102 Can that provision applywhen the payment is made after the employee in question has died? The

'ooH.R. REP. No. 99-426 (1985).oId. at 106 n.5.

102See I.R.C. § 102(c).


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source of the employer's making the payment is the status that the decedenthad as an employee before his demise. The payment is made in respect of thedecedent. But in what sense can the payment made after the employee's deathbe said to be of a benefit to the employee? A prominent treatise concludedthat the payment cannot be said to be of benefit to the employee unless it wasmade pursuant to an agreement or plan that existed while the employee wasalive.103 The treatise concludes that, in the absence of such an agreement orpractice, section 102(c) does not apply. It notes that the absence of an agree-ment or practice likely is also a condition for the satisfaction of the Dubersteinstandard; thus, section 102(c) adds nothing to the requirements for gift treat-ment in the case of death benefit payments."

While the position adopted by the treatise is consistent with the literallanguage of the statute, the Author disagrees with this conclusion.'1 The taxtreatment of death benefit payments was the subject of litigation in a size-able number of cases prior to the 1986 adoption of section 102(c).1o' Giventhat one of the apparent purposes for the adoption of section 102(c) was toreduce the amount of litigation that turns on subjective facts by drawing abright-line distinction, it is highly unlikely that Congress would have wishedto limit the provision to transfers to living employees-especially because somuch litigation over what constitutes a gift involved death benefit payments.It does not seem an abuse of the statutory language to read "for the benefitof an employee" as incorporating payments made in respect of an employee.The crucial factor should be that the payment arises out of an employmentrelationship.

To escape from section 102(c), it must be shown that the transferor was notan entity and that the payment was not compensation for the employee's pastservices. The latter requirement will be difficult to satisfy; it requires show-ing that a personal, noncompensatory purpose was a necessary and sufficientreason that the payment was made.

A similar question is whether section 102(c) applies to a payment to aretired employee, since the recipient is no longer employed by the payor.There is no apparent reason to doubt that section 102(c) is applicable. Suchpayments typically are severance pay in recognition of past services. The stat-ute's use of the word "employee" should be construed to include a formeremployee in light of the legislative purpose to minimize the role of subjectivefacts in determining whether payments arising out of an employment rela-

"See BITTKER & LOKKEN, supra note 63, 1 10.2.4; see also Williams v. Commissioner,2005-1 U.S.T.C. 5 50,163, 95 A.ETR.2d 764 (10th Cir. 2005).

"'0See BITTKER & LOKKEN, supra note 63, 10.2.4.' 5oAnother treatise co-authored by one of the authors of the Bittker and Lokken treatise is

ambivalent on this question but seems to favor applying section 102(c) to the payment. SeeBoRis . BiTrKER, MARTIN J. MCMAHON & LAWRENCE A. ZELENAK, FEDERAL INCOME TAxA-TION OF INDIVIDUALS 5.02[4] (3d ed. 2002).

o'"Estate of Carter v. Commissioner, 453 E2d 61, 667 (2d Cit. 1971); BITTKER & LOK-

KEN, supra note 63.


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tionship are taxable.1 o7 So, the payment will be income to the recipient unlessit can be shown to have come from an individual who had a personal reasonthat was both necessary and sufficient to the making of the payment.

B. Testamentary Transfers to an Employee

When section 102(c) applies, it prevents section 102(a) from excluding atransfer from gross income.' Because section 102(a) applies to both lifetimeand testamentary transfers, it would seem that section 102(c) will also applyto testamentary transfers to an employee.' 9 There are reasons, however, toconclude that it does not. Neither the regulations nor any other authorityaddresses that question.

The title to section 102(c) is "Employee gifts"; the title is part of the Actand was not merely an editorial insertion. The title suggests that the provisionapplies only to gifts. While a testamentary disposition sometimes is referredto as a gift, the fact that section 102(a) refers to "transfers by gift, bequest,devise, or inheritance," whereas the title to subsection (c) refers only to "gifts,"indicates that subsection (c) does not apply to testamentary transfers." 0

How much weight, if any, can be given to the title of a provision? Whilesection 7806(b) states that no inference of legislative purpose should bedrawn from the location or grouping of a Code provision, or from the tableof contents,"' that admonition does not apply to the title of a provision-which is as much a part of that provision as is the rest of its language. Whilethe title of a provision should not be conclusive, it is evidence of the scope ofthe provision. If the restricted scope of the provision that is indicated by thetitle is supported by the apparent policy for adopting the provision, it shouldbe given greater weight.

As noted in Part II, testamentary transfers to an employee have not causedthe administrative and litigation problems that dogged inter vivos transfers,where the subjective Duberstein standard proved difficult to apply. That isnot to say that there were no problems, but they were less troublesome thanthose attending inter vivos gifts. As noted in Part II, there were several casesand a private ruling that excluded a bequest or settlement of a claim againstan estate even though there was a prior agreement for services," 2 but thosedecisions are aberrational. Testamentary transfers have been excluded fromincome if there was no agreement during the employer's life that a bequestwould be made."' Moreover, in the absence of a prior agreement, it is likelythat a bequest will be motivated by feelings of affection rather than an effort

' 7See BirrER, MCMAHON 8C ZELENAK, supra note 105, 1 5.02{3] (preferring the view that

section 102(c) applies, but treating the question as an open issue).108I.R.C. § 102(c).

'"I.R.C. § 102(a).0 I.R.C. § 102(a)-(c).

1'11I.R.C. § 7806(b)."2 See supra text accompanying note 75."3 See supra note 69.


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to increase the compensation for past services. Bequests to employees are notunusual in the case of long-term household employees. It would be a rare sit-uation where the bequest is designed to encourage the employee to continueto be employed by the decedent's family, and it is unlikely that that situationwould arise frequently enough to stimulate a legislative response.

In the Author's view, the reference in subsection (c) to subsection (a) was aconvenient device to remove gifts to employees from the Duberstein standard.It is unlikely that Congress noted that the reference to subsection (a) therebyincluded testamentary transfers. The concededly sparse legislative historycontains no mention at all of testamentary transfers. The fact that the titleto subsection (c) refers only to gifts provides some support for the view thatCongress did not intend for the provision to apply to anything else. While theissue has not arisen, the Author has concluded that section 102(c) does notapply to testamentary transfers.

IV. Conclusion

Some critics of excluding gifts from income have complained that it is unfairto tax workers who earned their income through the sweat of their brow,while not taxing someone who has done nothing more than be the fortunaterecipient of another's largess."' Although that characterization has superficialappeal, it fails to take into account the reason that gifts are excluded andhow that exclusion complements the taxation of income that is saved, ratherthan consumed, in the year earned. Gifts are not excluded because of the roleof the donee; they are excluded in order to allow a taxpayer who has beentaxed on income to have a broad range of choices of how that income canbe used for consumption of assets or services. Having paid a tax on income,the taxpayer is allowed to use that income for consumption without incur-ring an additional income tax. Instead of consuming the income himself, ataxpayer may obtain greater utility from having someone the taxpayer lovesconsume it. The gift exclusion permits the taxpayer to have another personconsume the taxpayer's accumulated income. This broadening of the scope ofconsumption open to a taxpayer is consistent with the taxing of accumulatedincome, in that the tax on that income represents a tax on consumption thatwill occur at some future date---even if the consumption is made by someoneother than the taxpayer. The reason for excluding gifts focuses on the treat-ment of the donor rather than the donee. The donee benefits from a policythat maximizes the donor's choice of how his income will be consumed.

On its face, section 102(c) prohibits gift treatment for any transfer froman employer to an employee. However, an examination of the legislative his-tory of that provision, as well as Proposed Regulation section 1.102-1(f)(2), shows that there are exceptions to the application of section 102(c). Anemployee can occupy more than one status: in addition to being an employee,he can be a beloved relative or friend. If it can be shown that the transfer

" 4 See Klein, supra note 7.


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from the employer was made to the recipient in a capacity other than thatof an employee, section 102(c) will not apply. To meet that burden, it mustbe shown that a personal, noncompensatory purpose was the necessary andsufficient reason for the transfer. If section 102(c) does not apply, then thetransfer must satisfy the Duberstein standard of "detached and disinterestedgenerosity" to qualify as a gift. The Article discusses the conditions that mustbe satisfied for a transfer to an employee to be excluded from section 102(c)and to qualify as a gift under the Duberstein standard. The Author proposesfive conditions that must be satisfied. The Article examines the operation ofthe Duberstein standard and concludes that the standard's focus on the inten-tion of the transferor needs to be modified in certain circumstances.

Employee awards for accomplishments such as length or excellence of ser-vice cannot constitute a gift because of section 102(c). Consequently, they willbe included in income unless another statutory provision excludes them.

Payments made by an entity to an employee can sometimes satisfy theDuberstein standard, but it will not be possible for such payments to escapethe reach of section 102(c). Consequently, payments from an entity will failto qualify as a gift. There is a plausible basis for treating an entity's paymentas a constructive distribution to an owner of the entity, followed by a transferfrom that person to the employee. However, the complications that wouldfollow from that constructive series of transactions make it administrativelyundesirable to pursue that avenue unless there is strong evidence that theowner was the actual transferor.

Payments made to an employee upon retirement generally will be taxableunless a number of conditions are satisfied that, together, negate the inferencethat the payment is compensation for past services. Although the transferee isno longer an employee, section 102(c) should apply to the payment since itis attributable to an employment relationship. Even if the difficult hurdle ofshowing that the payment was not for past services is successfully overcome,if the payment is made by an employer who is an entity it will fail to qualifyas a gift.

Death benefits paid to the surviving spouse or other family member of adeceased employee often will qualify for gift treatment under the Dubersteinstandard, unless made pursuant to an agreement or preexisting policy.Contrary to the view of a leading treatise, the Author concludes that deathbenefit payments are subject to section 102(c). To escape from that provision,it must be shown that the transferor was not an entity and that the paymentdoes not represent compensation for the deceased employee's past services.That latter requirement will be difficult to satisfy. It must be shown that a per-sonal purpose was the necessary and sufficient reason for the transfer. If thedecedent's family has financial difficulties, and if there was a close relationshipbetween the employer and the decedent, that would be evidence supporting aclaim that the payment was made out of compassion and affection.

The literal language of section 102(c) makes it applicable to testamentarytransfers from a deceased employer. The Author concludes, however, that sec-


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tion 102(c) does not apply to them. Accordingly, a testamentary transfer toan employee will not be taxable unless made pursuant to an agreement.


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Documents

The Taxation of a Gift or Inheritance from an Employer